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Middle East Payoff?

Middle East reforms could present an opportunity for a few risk-taking companies.

Citigroup's(NYSE:C) announcement in late May that it would sell its 20% stake in Samba Financial appeared to be a logical exit from hostile territory.

Through the sale, Citigroup will depart the Kingdom of Saudi Arabia after nearly 50 years. The financial services giant denied that the transaction had anything to do with political considerations, and also indicated that it is exploring other opportunities in the region.

Even so, with the ongoing instability in the Middle East, investors did not appear overly concerned about the financial services giant's plans there. Indeed, it seems most do not see Middle Eastern investments as worthwhile, with the obvious exception of development of energy reserves.

At first glance, there are plenty of facts that support this negative assessment. But beyond the headlines, another story is taking shape that suggests the chances for reform may be better than ever. These developments could present a ripe opportunity for a few risk-taking companies.

Anemic foreign capital flows The Middle East remains a highly unpopular place for foreign enterprises. According to the World Trade Organization, global foreign direct investment (FDI) in 2003 increased in every developing area except North Africa and the Middle East. In fact, over the past several years, the level of this financing has collapsed. In 2003, foreigners poured $2 billion into the region, a sharp decline from $7.4 billion in 1998. Compared to other areas, the Middle East receives few dollars. Asia, for example, garnered $56.8 billion in FDI in 2003.

For anyone following international news, these statistics may seem unsurprising. The Israeli-Palestinian conflict, unrest in Iraq, and terrorist attacks in Saudi Arabia are all enough to give outsiders the jitters. In addition, most countries' economies are socialist relics, with legal and regulatory structures that provide many barriers to, and not enough protection for, foreign capital.

Need for changeAt the same time, there are signs that the Middle East can't afford to maintain the status quo for much longer. While energy resources have long played a leading role in development, the power of such assets to bring broad prosperity is rapidly diminishing. Dr. Marvin Zonis, professor emeritus of business administration at the University of Chicago, notes that OPEC's oil revenue has dropped precipitously.

In constant 2000 dollars, OPEC's sales amounted to $598 billion in 1980. In 2004, they are expected to be $231 billion. On a per capita basis, the picture is bleak, due to rapid population growth. In Saudi Arabia, for example, per capita income plummeted from $25,000 in 1980 to $8,000 in 2003. This decline reverberates elsewhere, since even non-oil producers, such as Egypt, rely on oil revenue indirectly in the form of tourist dollars from oil states.

In the midst of this gloom, there are glimmers of hope. Within the Middle East itself, there is growing recognition of the need for reform. The United Nations Development Program's Arab Human Development Report, authored by Arab scholars, calls on Arab countries to close a "growing knowledge gap" with the rest of the world through investments in education and greater openness and interaction with other nations. Many rulers seem willing to ignore this plea, but a select few are responding.

For its part, the U.S. government is encouraging reformers with a vigorous economic policy offensive. While the Bush administration's strategy is closely associated with the invasion of Iraq, the White House has been quietly pushing for greater economic liberalization. The hallmark of this initiative has been several free-trade agreements. The U.S. has signed such deals with Jordan, Israel, Morocco, and will soon seal a pact with Bahrain. For companies looking to grow, these countries and a few others may represent small windows into the Middle East and its 280 million inhabitants.

Early moversSlowly, more firms are warming to the Middle East. So far, many investments remain focused on traditional areas, such as banking and energy. Citigroup, for example, may be leaving Saudi Arabia, but is exploring expansion in Libya. The former pariah state, now unfettered by sanctions, is planning widespread privatization of its economy. American Express(NYSE:AXP) and J.P. Morgan(NYSE:JPM) are also reportedly considering initiatives, in addition to a number of energy concerns.

Most Middle Eastern economies remain closed, but the countries that do open up could serve as gateways into less hospitable markets. Bahrain, for instance, a tiny kingdom of just 650,000 people centrally located in the Persian Gulf, is itself a fairly minuscule opportunity. But Bahrain has agreements with surrounding states, and as a result, players operating there could have an easier time doing business elsewhere in the neighborhood.

British telecom concern C&W Wireless(NYSE:CWP), for instance, has parlayed its presence in the country into a contract to rebuild communications networks in Iraq. Alcoa(NYSE:AA) has taken steps to buy a 26% stake in Alba, Bahrain's state aluminum, after its competitor Alcan(NYSE:AL) made a similar move in Oman.

Finally, even though many of the Middle East's inhabitants disagree with U.S. policies, U.S. brands remain welcome. McDonald's(NYSE:MCD) operates throughout in several countries and has had success adapting to local palates, including offering something called the McArabia sandwich. Starbucks(NASDAQ:SBUX) is the most recent major U.S. brand to see growth opportunities. Earlier this year, the firm's chairman Howard Schultz toured the Middle East and remarked that he sees "huge potential" in the area for the coffee colossus.

The possibility that the Middle East could become a major growth area in the near future may seem exceedingly remote, considering its long stagnation and many of its inhabitants' current hostility toward the U.S. But the small chinks in the closed economic facade could rapidly give way to unprecedented openness. One need only look at Russia's transformation since the fall of the Soviet Union to see the possibilities. Companies braving the Middle East's challenging marketplace today stand a chance at a rich reward.

Fool contributor Brian Gormanis a freelance writer living in Chicago, Ill. He does not own shares of any companies mentioned here. The Motley Fool is investors writing for investors.